How business valuators estimate the DLOM in a volatile market

When valuing a business, recent market volatility may well translate into higher discounts for lack of marketability (DLOM) because investors generally will pay less for illiquid, risky investments. However, there’s a silver lining to economic uncertainty: It provides an opportunity for wealthy individuals to gift private business interests at significant discounts, potentially saving a substantial amount in taxes.

DLOM basics

Marketability is the ability to quickly or readily convert property to cash at minimal cost, according to the International Valuation Glossary — Business Valuation. Also implied is a high degree of certainty that an expected selling price will be realized.

The two most popular sources of empirical data valuators use to support DLOMs are restricted stock and pre-initial public offering (IPO) studies. These studies suggest that discounts for minority interests in private companies range from 30% to 50%. But the DLOM can vary significantly depending on the specific characteristics of the subject business interest.

Evaluating volatility

High volatility typically lowers marketability by making investments less attractive. But estimating private stock price volatility can be difficult because there aren’t published stock prices for privately held shares — and private transactions are few and far between. Recently, valuators have turned to public volatility metrics to capture the specific effect volatility has on private marketability discounts.

One popular gauge of market volatility is the Chicago Board Options Exchange Volatility Index® (VIX®). VIX measures the expected volatility of Standard & Poor’s (S&P) 500 index options over the next 30 days. Also known as the “fear index,” VIX tells whether investors expect sharp changes in market prices — either upward or downward.

Beyond volatility

Volatility is just one factor that affects marketability. Other considerations when estimating a DLOM include:

Put rights. These create a market for transferring ownership and, therefore, support a lower discount.

Pool of potential buyers. Business interests that have more potential investors generally warrant lower discounts.

Size and financial performance. Small companies, startups and underperforming companies may be perceived as high-risk ventures that warrant higher discounts.

Size of block. Large blocks of stock typically take longer to sell and have fewer potential buyers, justifying higher discounts.

Imminent sale or public offering. These situations effectively create a market for the company’s stock, which can lower the discount.

Availability of financial data. Companies without timely, accurate financial reports may warrant a higher discount.

Restrictions on ownership rights. Contractual provisions — for example, those contained in buy-sell agreements and shareholder agreements — that restrict stock transfers or set a fixed price for buyouts may increase the discount.

Dividends. Empirical studies show that dividend payments increase the desirability of a given investment and, therefore, reduce marketability discounts.

Valuators consider these same factors in other parts of their analyses. For example, these considerations may come into play when quantifying the discount for lack of control, blockage discounts, or the cost of equity (under the income approach). To avoid undervaluing a business interest, it’s important not to double-count risk factors.

Get it right

When quantifying a DLOM, it’s important to look beyond medians or averages from empirical studies. Experienced valuation professionals will make specific connections between the transaction data from the studies and the business interest in question. Contact us at 330-453-7633 to discuss what’s appropriate for your situation.

© 2022

Want to be notified of new articles like this? Sign-up Now!

  • This field is for validation purposes and should be left unchanged.
Partner with dedicated, expert accounting advisors.
Request A Free Consultation

More HK News

close

Search HK

Close
mature business woman using her computer

Still have questions?

Reach out to one of our experts for the financial guidance you deserve.

This Site Uses Cookies to Improve Your Experience

The use of cookies is required to deliver certain portions of our website, such as 3rd party educational resources and content. We also use cookies to track your basic website usage, which enables us to improve how our website meets your needs. If you decline, some areas of our site may be unavailable. Read our privacy policy for complete details.

Read Our Privacy Policy Agree To Cookies Deny Cookies